Please note that this article contains technical language. For this reason it is not recommended to readers without professional experience of this topic.

Summary

– Policy measures announced by the European Central Bank (ECB) fall short of expectations: no increase in the amount of monthly purchases
– Did the ECB Governing Council curb President Draghi’s ambitions?
– In the wake of the announcement the Euro rallied versus US dollar, bond yields rose, equities fell

After the 3 December policy meeting, the ECB announced several measures to support the eurozone economy and bring inflation closer to its target:

– The deposit rate was cut by 10bp to -0.30%. This means banks now have to pay 30% interest on excess reserves parked at the ECB and are being encouraged to lend funds instead of depositing them with the ECB.
– The ECB lengthened the period in which it will purchase assets. Until today, the quantitative easing programme (QE) had been set to run until September 2016, or longer if inflation remained too low. It will now run until March 2017. This should add EUR 360 billion to the quantitative easing programme and take its total to EUR 1 560 billion, keeping bond yields lower for longer.
– The ECB will reinvest the principal payments on the bonds purchased under the QE programme as they mature, for as long as necessary. This should contribute to loose liquidity conditions and an even more stimulative monetary policy stance.
– The ECB extended the range of assets it will purchase to include regional and local eurozone government bonds, thus tackling a possible scarcity of bonds resulting from the large scale of its QE programme. This step should also improve the credibility of the programme.

A disappointing package, overall

Financial markets were quite clear in their verdict of the ECB’s monetary policy announcements: they were disappointed. The euro immediately started to strengthen after the news that the deposit rate had been cut by only 10bp. It gained further during the ECB news conference when president Draghi made it clear that the monthly asset purchases were not going to be increased. Before the news conference, the euro had traded at 1.055 USD per EUR and it rose to almost 1.09 as Draghi spoke (see Exhibit 1 below). By the end of the day the euro had undergone its biggest intraday rally (+4.5%) versus the US dollar since 2009. Equities dropped, most sharply in Germany, where the DAX fell by over 2%. Bond yields rose; in Germany by 8bp and by more in ‘peripheral’ countries in the eurozone. Italian yield spreads widened by 7bp and Spanish spreads by 5bp.

Exhibit 1: The ECB’s announcement on 3 December 2015 triggered the euro’s biggest intraday rally (+4.5%) versus the US dollar, since 2009. This suggests to us that the ECB’s measures fell short of market expectations (the graph shows number of US dollars per euro for the period from 04/12/14 to 04/12/15).

Source: Bloomberg, as of 4 December 2015

Probably the biggest disappointment was that the amount of monthly asset purchases was left unchanged at EUR 60 billion. In recent weeks, ECB officials, including Draghi, had said that all policy measures would be reviewed and had underscored the flexibility of the asset purchase programme. This had widely been interpreted as a hint that QE would be expanded. The decision to reinvest principal repayments was meant to placate markets, but it was seen as not enough to compensate for the absence of a substantial increase. Given that the QE programme only started this year and most of the bonds the ECB has bought so far have maturities of more than two years, reinvestments will be minimal for the time being.

The cut in the deposit rate was also disappointing. We think markets had expected at least a 15bp reduction, while 20bp had also been mentioned frequently. Hence the appreciation of the euro after the announcement of the relatively modest cut.

Finally, as regards the decision to broaden the range of eligible assets, Draghi did not give any numbers of the amounts of bonds outstanding that the ECB can now buy.

Why this restraint?

What were the reasons for the ECB to disappoint the markets? The eurozone economy is recovering gradually and GDP growth is forecast at 1.5% this year, accelerating to 1.7% in 2016 and 1.9% in 2017. These forecasts by the ECB are broadly unchanged from its September projections. These growth rates are above what we think is trend growth and should therefore help lower unemployment. According to the ECB, monetary policy is already supporting this recovery, with further help coming from reduced fiscal austerity and low oil prices. But inflation remains far from the central bank’s target of a rate just below 2% and inflationary pressures will take time to build. The ECB now expects 0.1% inflation in 2015, rising to 1.0% next year and 1.6% in 2017. These forecasts have all been revised downward and all fall short of the target

While the ECB sees it as positive that the correlation between oil prices and inflation expectations has mostly disappeared – which would imply that markets are looking more at the ECB’s stimulative monetary policy – it was not convinced that the existing policy measures were effective enough to ensure that inflation would start moving towards the target. When asked why the ECB did not expand the monthly QE purchases, Draghi pointed to the new reinvestment policy – which had been widely expected anyway – and said that these new measures would be adequate. The ECB had to recalibrate its monetary policy due to changing international factors such as economic weakness in emerging markets and the euro’s appreciation from its March low. The ECB can be expected to continue to recalibrate its stance when necessary.

Have Draghi and the doves overplayed their hand?

Of course, markets can be seen as spoiled children for whom monetary policy is never loose enough. But remember that the ECB itself had raised the expectations for a large package from today’s meeting. For example, on 20 November, Draghi said in a speech at the Frankfurt European Banking Congress that QE was a powerful and flexible instrument that could be adjusted in size, composition and duration. He said that the level of the deposit rate could empower the transmission of QE and that if the measures employed at that time were insufficient for inflation to reach the ECB’s target, “we will do what we must to raise inflation as quickly as possible”. This echoed the “we will do whatever it takes” speech in July 2012 which helped to stem the eurozone fiscal crisis. What was missing last month was that Draghi did not add that we should believe him that it would be enough. This time it wasn’t.

To us, it looks like Draghi and the other doves on the ECB’s rate-setting council overplayed their hand. At the news conference, Draghi acknowledged that today’s decisions had not been made unanimously. Our take on this is that the doves wanted more, but were held back by the hawks.

What’s next?

For now, the main implication from a global perspective is that these moves by the ECB remove a hurdle for a rate hike by the US Federal Reserve (Fed) in December. If the ECB had over-delivered and the euro had weakened towards parity versus the US dollar, it would have been harder for the Fed to ‘sell’ the need for a rate hike since US manufacturing is already struggling with the dollar’s appreciation to date.

Within the ECB, the discussion on the need for further easing may continue, especially if inflation stays too low for comfort. Today, Draghi again said that the QE programme is flexible.